“More than insignificant” is key judgment in leases proposal

CPAs may have difficulty at times determining what constitutes “more
than insignificant” consumption of a leased asset by a lessee under a
proposed standard being jointly developed by FASB and the
International Accounting Standards Board (IASB), according to a
webcast conducted by the boards on Thursday.

On rare occasions, a lessee and lessor may even reach different
conclusions about which recognition model to use for the same asset as
leases are placed on the balance sheet, according to the boards’ staff.

But the boards intend to provide significant guidance to minimize
these application concerns when they issue a second exposure draft on
leases in the fourth quarter of 2012.

“We will be including in the revised exposure draft a number of
models,” said FASB Practice Fellow Cullen Walsh. “…Following the
publishing of the exposure draft, the boards will continue to perform
a significant amount of outreach to make sure the proposals are well understood.”

The proposed leases standard provides for two different ways for
both lessors and lessees to recognize leases, depending on the
characteristics of the lease.

When the lessee consumes a more than insignificant portion of the
asset, the lessee must recognize the lease as a nonfinancial asset
measured at cost, less accumulated amortization. The combination of
the amortization charge and the interest expense on the lease
liability would result in a total lease expense that would generally
decrease over the lease term.

But if the lessee is paying only for use of the asset and does not
consume a more than insignificant portion of the asset, expense
recognition can follow a straight-line pattern, with total lease
payments allocated evenly over the lease term.

Meanwhile, the lessor accounts for the lease as a sale of a portion
of the lease asset, recognizing a receivable and a retained interest
in that residual asset, when the lessee consumes a more than
insignificant portion of the leased asset. When a more than
insignificant portion of the leased asset is not consumed, the lessor
recognizes straight-line lease income.

The question, of course, is what constitutes a “more than
insignificant” portion of the leased asset. FASB and IASB staff
members provided examples. In general, equipment and vehicle leases
tend to depreciate heavily during the life of a lease, so significant
consumption occurs, staff members said.

In property leases, the asset usually does not depreciate—and
sometimes can increase in value—over the lease period. So consumption
of the asset by the lessor generally is considered to be insignificant.

A three-year real estate lease and a 10-year lease on commercial
property with an assumed economic life of 40 years were listed as
examples where insignificant consumption occurs. Examples of leases
with more than insignificant value consumed by the lessee included:

A 10-year airplane lease.

A three-year lease on a car
with an assumed economic life of six years.

A four-year
lease on a truck with an economic life of 10 years.

But two examples did not definitively fit into either category
and would require judgment, according to the staff. The “more than
insignificant” benchmark could be difficult to apply to a five-year
lease on a vessel with an economic life of 40 years, and a 30-year
lease on commercial property with an economic life of 40 years.

IASB Senior Technical Manager Patrina Buchanan said that in those
cases, a broader set of circumstances would be needed to determine
which recognition model to use. She said the boards are unlikely to
define “insignificant” using numbers, but plan to include application
guidance and examples to be helpful in the re-exposure draft.

She said it is possible that in rare instances a lessor and lessee
could make different decisions on how to classify the same lease, even
though they will be looking at the same wording and guidance within
the standard.

“Depending on exactly how they apply those words, it may be possible
that they might get to different conclusions,” Buchanan said. “I think
we would expect the vast majority of the time that they reach the same
conclusion, but each might be looking at the same words, maybe, in a
slightly different way.”

Buchanan said it should be easy in most cases to decide which method
to use.

“Deciding what side of the line you are on should be a pretty
straightforward task, and really judgment should only need to be
applied to relatively few leases,” Buchanan said. “However, in saying
that, I think this will be an area where we will be particularly keen
to hear from constituents in terms of the operationality of the proposal.”

Financial instruments stalled

FASB’s joint convergence project with the IASB on financial
instruments hit a snag Wednesday when FASB’s staff revealed
stakeholder concerns on the model’s treatment of impairment.

Before proceeding to an exposure draft, FASB has a number of topics
it wants to address, including constituent concerns regarding the
operability, auditability, and understandability of the proposed model.

The FASB staff is summarizing the feedback received and will present
it to the board and seek direction. The staff said flexibility exists
in the calendar, and that should not have an adverse effect on the
project.

But IASB Chairman Hans Hoogervorst was frustrated. He said he finds
it “deeply embarrassing” that the boards have not been able to come up
with an acceptable answer in the project after three years.

“I find that unacceptable,” Hoogervorst said. “So I would really
hope that, when your staff does this outreach, that they do it with an
attitude of getting things fixed and not letting it unravel.”

FASB Chairman Leslie Seidman said the staff plans to work
expeditiously to keep the project moving forward. It had been hoped
that a final standard in the project would be issued by the middle of 2013.

“In order to move forward confidently that the exposure draft is
going to represent an understandable, operational improvement in
financial reporting, we believe it’s important to address these issues
now,” Seidman said.